Summary

Adobe's (NASDAQ:ADBE) success in following Microsoft (NASDAQ:MSFT) into cloud delivery of its applications offers an important lesson to all software vendors.

Adobe reported earnings of $254 million, or 51 cents per share, on revenue of $1.383 billion during the first three months of the year. This compared to earnings of $85 million, or 17 cents per share, and revenue of $1.1 billion a year earlier.

By moving its software online under the Creative Cloud brand, Adobe has been able to steadily increase revenues, operating income and margins. For the quarter, research expenses were up about 10% while revenues from subscriptions rose 12%, and service and support revenues rose 37%, from $51 million to $72 million. Sales and marketing expenses jumped 21%, but those increases might be expected to moderate in the future, meaning further margin expansion is possible.

Small wonder that the stock popped after earnings, rising from $90 to $96/share overnight, before settling down over a few days' trading to its current level of about $92.50. You can say that the company is on Cloud 9 but there is a warning in that.

The software business has now been transformed. I'm old enough to remember floppies, then CDs and DVDs. Software updates were one thing, but cloud is quite another. Cloud software is updated once, on the cloud, and that update immediately becomes available to everyone, because they're no longer working on their local machines but online. Over time, this provides a huge pop to earnings for companies that make the transition.

But it also lowers the barrier to entry for new players. These won't be companies that go directly against Adobe or against Microsoft. They will, instead, offer add-ins, small niche programs that do things the big boys don't do, but that a subset of high-end customers need done. The companies will grow, they will multiply, and while some may be bought out by the big boys, others will combine to form real competitors.

In a way, this is how Adobe itself was constructed. The original company was founded on desktop publishing and eventually had to acquire things like video editing (through Macromedia) that built out its suite. These companies did not go directly against Adobe. They created new niches, expanded them, and eventually challenged them as large Adobe clients demanded more.

This could happen, for instance, in areas like virtual and augmented reality. Software for such devices only starts with their user interfaces. There will be applications, there will be content tools, and these will be made quickly available to users via clouds. Adobe may think it can wait on these opportunities to become "ripe," but clouds let companies scale from 0 to 100 very quickly. Probably more quickly than even Adobe imagines.

The point is that Creative Cloud, and cloud applications in general, create a new world for software designers and everyone involved in the business. We're seeing the benefits now, but downsides are sure to follow. They always do. Which is why the stock did not jump nearly as high as some might have expected, given the results, and why it was right not to do so.

Disclosure:I am/we are long MSFT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.